Strategic Risk Shifting and the Idiosyncratic Volatility Puzzle: An Empirical Investigation

2020 ◽  
Author(s):  
Zhiyao Chen ◽  
Ilya A. Strebulaev ◽  
Yuhang Xing ◽  
Xiaoyan Zhang
Keyword(s):  
Stock Returns ◽  
Risk Premium ◽  
Empirical Investigation ◽  
Empirical Support ◽  
Idiosyncratic Risk ◽  
Market Risk ◽  
Idiosyncratic Volatility ◽  
Risk Shifting ◽  
Market Risk Premium ◽  
Strategic Risk

We find strong empirical support for the risk-shifting mechanism to account for the puzzling negative relation between idiosyncratic volatility and future stock returns. First, equity holders take on investments with high idiosyncratic risk when their firms are in distress and receive less monitoring from institutional holders as well as when the aggregate economy is in a bad state. Second, the strategically increased idiosyncratic volatility decreases equity betas, particularly in bad states when the market risk premium is high. The negative covariance between the equity beta and the market risk premium causes low and negative returns and alphas in firms with high idiosyncratic volatility. This paper was accepted by Tomasz Piskorski, finance.

scholarly journals Idiosyncratic risk and the cross-section of stock returns: the role of mean-reverting idiosyncratic volatility

2018 ◽  
Vol 294 (1-2) ◽  
pp. 419-452 ◽  
Author(s):  
Stanislav Bozhkov ◽  
Habin Lee ◽  
Uthayasankar Sivarajah ◽  
Stella Despoudi ◽  
Monomita Nandy
Keyword(s):  
Stock Returns ◽  
Risk Premium ◽  
Empirical Studies ◽  
Idiosyncratic Risk ◽  
Risk Tolerance ◽  
Idiosyncratic Volatility ◽  
Market Participants ◽  
The Mean ◽  
The Difference ◽  
Risk Metric

Abstract A key prediction of the Capital Asset Pricing Model (CAPM) is that idiosyncratic risk is not priced by investors because in the absence of frictions it can be fully diversified away. In the presence of constraints on diversification, refinements of the CAPM conclude that the part of idiosyncratic risk that is not diversified should be priced. Recent empirical studies yielded mixed evidence with some studies finding positive correlation between idiosyncratic risk and stock returns, while other studies reported none or even negative correlation. We examine whether idiosyncratic risk is priced by the stock market and what are the probable causes for the mixed evidence produced by other studies, using monthly data for the US market covering the period from 1980 until 2013. We find that one-period volatility forecasts are not significantly correlated with stock returns. The mean-reverting unconditional volatility, however, is a robust predictor of returns. Consistent with economic theory, the size of the premium depends on the degree of ‘knowledge’ of the security among market participants. In particular, the premium for Nasdaq-traded stocks is higher than that for NYSE and Amex stocks. We also find stronger correlation between idiosyncratic risk and returns during recessions, which may suggest interaction of risk premium with decreased risk tolerance or other investment considerations like flight to safety or liquidity requirements. We identify the difference between the correlations of the idiosyncratic volatility estimators used by other studies and the true risk metric the mean-reverting volatility as the likely cause for the mixed evidence produced by other studies. Our results are robust with respect to liquidity, momentum, return reversals, unadjusted price, liquidity, credit quality, omitted factors, and hold at daily frequency.

The Market Risk Premium and Long-Term Stock Returns

1993 ◽  
Vol 19 (4) ◽  
pp. 63-72 ◽  
Author(s):  
William R Reichenstein ◽  
Steven P. Rich
Keyword(s):  
Stock Returns ◽  
Risk Premium ◽  
Market Risk ◽  
Market Risk Premium

The Cross Section of Expected Returns with MIDAS Betas

2011 ◽  
Vol 47 (1) ◽  
pp. 115-135 ◽  
Author(s):  
Mariano González ◽  
Juan Nave ◽  
Gonzalo Rubio
Keyword(s):  
Cross Section ◽  
Risk Premium ◽  
Market Risk ◽  
Ordinary Least Squares ◽  
Mixed Data ◽  
Expected Returns ◽  
Data Sampling ◽  
Cross Sectional ◽  
Market Risk Premium ◽  
The Cross

AbstractThis paper explores the cross-sectional variation of expected returns for a large cross section of industry and size/book-to-market portfolios. We employ mixed data sampling (MIDAS) to estimate a portfolio’s conditional beta with the market and with alternative risk factors and innovations to well-known macroeconomic variables. The market risk premium is positive and significant, and the result is robust to alternative asset pricing specifications and model misspecification. However, the traditional 2-pass ordinary least squares (OLS) cross-sectional regressions produce an estimate of the market risk premium that is negative, and significantly different from 0. Using alternative procedures, we compare both beta estimators. We conclude that beta estimates under MIDAS present lower mean absolute forecasting errors and generate better out-of-sample performance of the optimized portfolios relative to OLS betas.

An Empirical Examination of Ex AnteEstimates of the Market Risk Premium

2014 ◽  
Vol 23 (2) ◽  
pp. 51-58 ◽  
Author(s):  
Austin Murphy ◽  
Liang Fu ◽  
Terry Benzschawel
Keyword(s):  
Risk Premium ◽  
Market Risk ◽  
Empirical Examination ◽  
Market Risk Premium
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